Elementary Techniques to Avert Big Loss in Day Trading

Unfortunately, day trading is like a fascinating casino for most of the traders but business for a very few who manage to earn their bread and butter from it. Due to the ‘get rich quick’ approach, new traders burst their trading accounts in the first few weeks. The acquisitive nature of traders leads to a success rate of less than 1% in this business. In this article I will discuss a few important technical as well as psychological issues, in trade execution and trade management, that new and breakeven day traders have been facing. You will also learn some solutions to these problems.

Be Patient with Entries at Market Open

Sam is a new enthusiast in the stock market. He has already busted his account once and promised himself to follow discipline this time. Every day he drives to his broker’s office at 9 am. He opens his terminal and eagerly waits for market to open. Today his initial bias is bearish. The market opens in red but he wants to wait for his setup. Soon he observes a huge red candle. Now he is very confident with his bias but also caught by fear of missing out. Swayed in his emotions, he takes a short position at the low of very large 5-minute candle. But then he finds that the market is turning its back on him. He is feeling numb but still waiting. The market takes a U-turn and breaks its morning highs. Sam ends up losing a sizeable portion of his capital again.

What technical mistake Sam just made?

At the market open, candles are generally very wide so stops would be big. Even on a 5 min chart of the trader’s favorite Bank Nifty, a single candle could range anywhere between 100 to 200 points (sometimes even more) on an average basis.

 

 

Wide candles lead to high volatility, so things happen at a very face pace. It demands quick decision-making on part of traders. They have to be quicker in trade executions, while at the same time, following every trade management principle. But due to their compulsive and impatient attitude, most traders generally get trapped on the wrong side at market open. They take high-risk entries and are cornered by the professionals right in the first few minutes of trading.

Statistically, if a trader is taking a big risk at the open and stopped out, then 70% of the time he won’t be able to cover that loss by the End of Day (EOD). For the rest of 30% of cases, he will cover only if he doesn’t overreact to his loss and follow his edge religiously. If he is stopped for the second time, it becomes almost impossible for him to recover the entire loss. In such cases, profit and loss psychology plays a vital role than any other factor.

A new trader should keep in mind that the market would take its own course to pick a direction. He should not try to impose his will on the market. Fighting instinct may work well for soldiers at the frontline but not for traders. The trader has to wait till the stock/index gets as close to the high probability trade zone as possible. Once his/her low-risk setup is complete there should be no hesitation in trade execution.

Practice to Reduce Risk

Sam made a mistake by taking a huge risk at the market open. The first aim of every trader (even professionals) is to reduce their risk in the market. So when is the right time to take trades?

It’s normal to see volatility settling down after the first 30 to 60 minutes of a trading session. By that time bulls and bears would have shown their hands. Wide range opening candles would be followed by narrow range candles. Narrow candles mean reduced risk, as stop placement can be done under the narrow congestion zones, which is perfect for any trader.

 

It’s not uncommon to see, on intraday timeframes like 5/15minute, the markets throwing one or two low-risk trading opportunities in one trading session. Traders need to practice waiting for such trades rather than hoping on to high-risk ones.

Position Size Manoeuvre

In contrast to Sam, Jack is an experienced day trader in stocks. He is patient as well as disciplined. He waits for the market to find its direction and then takes low-risk entries. Let us see how he manages to enter the market.

Jack has found a solution to mitigate volatile openings. He learned the Split principle. He buys 1/3rd or 1/2 position on first pullback/consolidation. Even if he gets stopped, his loss would be minimal. This way his chances of covering the loss increase to 90%. He adds more shares at will on the second pullback or when it is confirmed that he has picked the right direction.

 

Unfortunately, one lot of derivative traders do not have the luxury that Jack has. They can’t split their position into partial buys and sells. They need multiple lots to follow the above strategy. However, one lot of traders may shift to equity trading which has much more flexibility in position sizing compared to derivatives.

Control Exits — Make Profits

Just like hasty entries, early exits would not let you be a profitable trader. You need to give your trade some time, maybe an hour or two, to generate results. But if the trade is taking too long and not moving at all, it could end up being a difficult one. But this scenario will provide ample opportunities to exit the trade at breakeven or at a small profit/loss.

In general, profitable trades won’t let you wait for too long. Once you are getting 1:2 or 1:3 on a trade, you can book partial if possible; book full profit, or lock your profit by trailing stop loss as shown in the two-day chart of Reliance Industries below.

 

Favorable Risk-Reward Would Pay in the Long Run

When reward in a trade is more than the risk involved, then risk-reward is said to be favourable. Now let’s statistically prove how it favors traders. Say Jack took 100 trades with a 1:2 risk-reward ratio. He made a profit in just 50 out of 100 trades and lost in the other 50. Means he made 100 points in winning trades and lost 50 points in others. With just a 50% success rate his net profit would still be 50 points. Jack just follows this discipline to maintain his consistency.

After entering a trade, the only thing a trader can control is the risk. Reducing the risk to its minimum is one of the most important objectives of the trader. It can be done by trailing the stop loss below important zones. At the same time, the trade should be left with enough room to breathe. This means the trailing stop should not be too tight as it will kill the trade too early.

Know When to Hold Your Horses

Perhaps it’s difficult for many newbies like Sam to digest a loss. They would like to recover it quickly. So in the next trade, they just double their quantity, ignoring the fact that the risk is also doubled. This is one of the main reasons why most day traders lose their entire capital in the first few weeks/months of their short career.

The correct approach is to fix maximum loss per trade (1-2% of capital) and by the number of shares accordingly. One also needs to fix the maximum loss per day. If maximum loss per day is hit, stop trading. Opportunities will appear the next day.

One has to divide the risk in Rupees with predetermined stop-loss points to get the number of shares one should be buying or short selling in a trade.

 

As an example, say Jack has a capital of 5lacs and he wants to buy Reliance for trading. It is trading at Rs2009 and his stop-loss comes at Rs1989 that is 20 points. The number of shares he can buy with 1% risk on his capital would be:

No. of Shares = (500000*1/100) / 20 = 5000/20 = 250

With this approach, the trader will be taking a calculated risk which may help him become a profitable trader in the long run.

What to trade?

The new traders would read one or two books on technical analysis; watch a couple of YouTube videos, or join a technical analysis course and dive into live markets with real money. Soon they will be lost in the world of thousands of stocks and end up losing. They miss the most crucial part of trading that is, what to trade. Most traders would lean upon paid tipsters; CNBC gurus; or broker’s advisory for a perspective before they will trade. But unfortunately, this method does not pay off.

I would like to suggest three simple ways for stock selection.

Momentum: It is day traders favourite style. Time is a big constraint for day traders so they need to pick something that is in trend today. The momentum stocks would either hit target or stop without testing traders’ patience. Generally, top 5 gainers/losers of the day offer momentum buy/sell opportunities much faster than the other stocks. Secondly, these stocks attract enough liquidity. (Tip – before taking trades just have a look at daily/hourly charts to know the overall structure of the stock. This would prevent you from buying into resistance and selling into support.)

Favourite List: Traders can also make a list of 10-20 favourite liquid stocks. They should mark all the important levels on the charts and wait for a promising setup or pattern in any of them. This method is solid and helps new traders to constantly gain trading skills. Traders can also use this method for swing trading purpose, where the trade is kept for more than one day.

Trade Index Futures: This method is suitable for derivative traders. Reason being it’s easy to analyse and keep watch of one or two instruments rather than a bunch of stocks. Traders can pin point their entry/exit more accurately due to strong focus. Also the index futures provide momentum as well as much sought out liquidity for day trading.

Final Thoughts

Day trading is like a see-saw. Market movement may be influenced by economic, political, or geographical news multiple times in a single trading session. Under such an uncertain environment buyers or sellers may get overwhelmed anytime. Anything that can save a trader’s capital is ‘discipline’. The techniques discussed in this article would help traders to gain discipline. It would be better to avoid entries in a hurry or getting too ambitious with the targets. The trader needs to wait for opportunities and trade with the primary trend on higher timeframes.

Practice for reducing the influence of greed and fear factors should be one of the primary objectives of aspiring traders. A business approach rather than money approach to trading would help to eliminate the above factors in the long run. If a trader is finding himself uncomfortable with the volatility of smaller timeframes, he can shift to higher timeframes such as 30/60minutes and manage the risks accordingly. As an alternative he can start from short-term investing or swing trading where he can practice decisions making at a slower pace.

It is said that humans need 21 days to change any habit. Traders need to know their bad trading habits by keeping a trading journal and then practice to renounce those habits one at a time. In my personal view, to learn the most difficult profession in the financial world, it would take more than just a few days of your life.

Author: JJSingh